Copyright 2000 Ian H Giddy International Financial Management

n www. stern. nyu. edu/~igiddy/ifmx. htm

International Financial Management Prof. Ian Giddy Stern School of Business, New York University

International Financial Management of international assets l Management of international liabilities l Management of

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING PORTFOLIO CAPITAL M&A Copyright © 2000 Ian

What is Special about Corporate Finance in the International Environment? l Financial markets are

What are the Global Financial Markets? l l l The Foreign Exchange Market The

The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a

Where the Eurocurrency Market Fits In US Domestic Market EUR 0 CURRENCY MARKET Eurodollar

Interest Rate Linkages in the International Money Market Two stories to tell: l Domestic

Domestic versus Euro The Eurodollar Premium Market price of risk versus Cost of regulation

Covered Interest Arbitrage Copyright © 2000 Ian H. Giddy International Financial Management 25

Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and

Linkages Between Eurocurrency Rates Interest rate differential Forward premium Copyright © 2000 Ian H.

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Forward premium Copyright

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Uncovered interest rate

Interest-Rate Parity $1 (1 + / E$) = ($1/ S t )(1 + /EBP)

Example: Anglo’s Funding l Anglo-American, the natural resources conglomerate, is seeking 3 -month US$

Anglo’s Answer It’s cheaper for Anglo-American to borrow in the US CP market. Reason:

Unbiased Forward Rate Theory EXCHANGE RATE Spot Forward Actual Today Copyright © 2000 Ian

Unbiased Forward Rate Theory EXCHANGE RATE Probability distribution of actual exchange rate Spot Forward

Unbiased Forward Rate Forward premium or discount = Expected annual rate of change of

International Fisher Effect INTEREST RATE DIFFERENTIAL Copyright © 2000 Ian H. Giddy International Financial

International Fisher Effect /E$ = /EDM + E(R$/DM ) That is, Interest-rate differential equals

Cost of Hedging Copyright © 2000 Ian H. Giddy International Financial Management 41

Corporate Hedging Decisions: Frutas Amazonas Exporting bananas to Spain, get paid in Spanish pesetas.

Corporate Hedging Decisions: Frutas Amazonas Continue funding in U. S. dollars. The peseta might

Frutas Amazonas Copyright © 2000 Ian H. Giddy International Financial Management 44

Frutas Amazonas Copyright © 2000 Ian H. Giddy International Financial Management 45

Law of One Price p=Sp* The Price of Tin In New York 273 c

Purchasing Power Parity: Theory and Evidence S t=1 -St St = I-I* 1+I* EXCHANGERATE

Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate

Inflation & Interest Rates US Expected Inflation Rate 2% Canadian Expected Inflation Rate 7%

Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest

The Linkages Again Relative excess money supply 1 2 4 Relative interest rates 5

A Framework Country A Country B DOMESTIC ECONOMIC POLICIES INFLATION RATE EXCHANGE RATE INTEREST

Conclusion: Corporate Exchange Rate Risk l Exchange Rate Risk is the risk arising from

Turkey, 1995 Turkish Lira: Down 33. 5% Copyright © 2000 Ian H. Giddy International

Turkey, 1995 Turkish prices: up 83. 8%! Turkish Lira: Down 33. 5% Copyright ©

Copyright © 2000 Ian H. Giddy International Financial Management 62

www. giddy. org Copyright © 2000 Ian H. Giddy International Financial Management 63

Copyright © 2000 Ian H. Giddy International Financial Management 64

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INTERNATIONAL FINANCIAL MANAGEMENT

n www. stern. nyu. edu

n www. stern. nyu. edu/~igiddy/ifmx. htm

n www. giddy. org

International Financial Management Prof. Ian Giddy Stern School of Business, New York University

International Financial Management of international assets l Management of international liabilities l Management of cross-border financial risks l Cross-border funds transfers l These depend on the environmental features of international finance-notably, the global financial markets Copyright © 2000 Ian H. Giddy International Financial Management 8

What is Special about Corporate Finance in the International Environment? l Financial markets are partially linked, partially separated by national jurisdications l Exchange rate fluctuations affect revenues, costs and valuation of firms l The competitive international financial markets offer special tools, opportunities and risks Copyright © 2000 Ian H. Giddy International Financial Management 10

What are the Global Financial Markets? l l l The Foreign Exchange Market The Derivatives Domestic and International Money Markets Domestic and International Capital Markets Beyond the Money and Bond Markets: International Equity and Commodity Markets Using the Global Capital Markets: Investors’ and Issuers’ Perspectives Copyright © 2000 Ian H. Giddy International Financial Management 11

The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States” l Separation of currency, institution and jurisdiction l Why do people want Eurocurrency deposits and loans? l Why is LIBOR the world’s key benchmark rate? Copyright © 2000 Ian H. Giddy International Financial Management 14

Where the Eurocurrency Market Fits In US Domestic Market EUR 0 CURRENCY MARKET Eurodollar Market Euro-Deutsche Market Euro-Yen Market Copyright © 2000 Ian H. Giddy German Domestic Market Japanese Domestic Market International Financial Management 16

Where the Eurocurrency Market Fits In US Domestic Market EUR 0 CURRENCY MARKET Eurodollar Market Euro-Commercial Paper Market Copyright © 2000 Ian H. Giddy German Domestic Market Euro-Deutsche Market Foreign Exchange Market Euro-Yen Market Euro-Floating Rate Note Market Japanese Domestic Market Straight Eurobond Market International Financial Management 17

Interest Rate Linkages in the International Money Market Two stories to tell: l Domestic vs. Euro l Eurocurrency A vs. Eurocurrency B Domestic Market A Treasury Bill Treasury Bond Copyright © 2000 Ian H. Giddy Bank Deposit Corporate Bond The Euromarkets Euro Deposit Market Euro Bond Market Domestic Market B Bank Deposit Corporate Bond Treasury Bill Treasury Bond International Financial Management 18

Domestic versus Euro The Eurodollar Premium Market price of risk versus Cost of regulation l Eurodollar vs. U. S. Interest Rate Effective cost of domestic deposit = (interest rate + FDIC fees) (1 - reserve requirement) l Capital controls and divided credit markets Copyright © 2000 Ian H. Giddy International Financial Management 19

Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUSFORThe Dealing. SPOT Room WARD TOMER Foreign Exchange Dealing Money FUNDING Copyright © 2000 Ian H. Giddy EUROCURRENCY Market Dealing International Financial Management 26

Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUSTOMER SPOT FORWARD Foreign Exchange Dealing Money FUNDING Copyright © 2000 Ian H. Giddy EUROCURRENCY Market Dealing International Financial Management 27

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Forward premium Copyright © 2000 Ian H. Giddy Expected % change in exchange rate International Financial Management 30

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Forward premium Copyright © 2000 Ian H. Giddy Uncovered interest rate parity Expected % change in exchange rate International Financial Management 31

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Uncovered interest rate parity Expected % change in exchange rate Forward premium Unbiased forward rate Copyright © 2000 Ian H. Giddy International Financial Management 32

Interest-Rate Parity $1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt where St is the spot exchange rate (dollars per British Pound) and Fnt is the forward rate. to a close approximation, (/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100 Interest-rate differential = forward premium or discount Copyright © 2000 Ian H. Giddy International Financial Management 33

Example: Anglo’s Funding l Anglo-American, the natural resources conglomerate, is seeking 3 -month US$ funding. u. Anglo can fund in the US CP market at 5. 5% u. Or in the Eurosterling market at 6. 7% u. The BP is: spot $1. 5484, 3 -mo forward $1. 5454 u. Which is cheaper? Copyright © 2000 Ian H. Giddy International Financial Management 34

Anglo’s Answer It’s cheaper for Anglo-American to borrow in the US CP market. Reason: u. US: simply borrow for 3 months q Cost: $1(1+5. 5%/4) = 1. 01375 u. UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3 -mo forward rate to repay the pounds q Cost: Copyright © 2000 Ian H. Giddy ($1/1. 5484)(1+6. 7%/4)1. 5454 = 1. 01478 International Financial Management 35

Unbiased Forward Rate Theory EXCHANGE RATE Probability distribution of actual exchange rate Spot Forward Actual Today Copyright © 2000 Ian H. Giddy TIME In three months International Financial Management 37

International Fisher Effect /E$ = /EDM + E(R$/DM ) That is, Interest-rate differential equals Expected annual rate of change of exchange rate Copyright © 2000 Ian H. Giddy International Financial Management 40

Corporate Hedging Decisions: Frutas Amazonas Continue funding in U. S. dollars. The peseta might get stronger in the next three months, from $1=128 pesetas to $1=126 pesetas. This could be the cheapest l Switch funding to pesetas, despite the slightly higher cost l Borrow in dollars, but hedge the exchange risk in the forward market. l Copyright © 2000 Ian H. Giddy International Financial Management 43

Law of One Price p=Sp* The Price of Tin In New York 273 c per lb. = US$6. 02 per kilograma On the Kuala Lumpur Market 15. 37 ringgit per kilogram =US 5. 70 per kilogramb a 1 avoirdupois pound = 0. 45359 kilograms b. US$1 = 2. 6965 Malaysian ringgit on the date of calculation c 1 tonne = 1000 kilogram. All data taken from the Commodities section of the London Financial Times. Copyright © 2000 Ian H. Giddy On the London Metal Exchange US$5830 per tonne = US 5. 83 per kilogramc International Financial Management 46

Purchasing Power Parity: Theory and Evidence S t=1 -St St = I-I* 1+I* EXCHANGERATE CHANGE n MEXICO 1994 RELATIVE INFLATION n Copyright © 2000 Ian H. Giddy JAPAN 1995 International Financial Management 47

Deviations from Purchasing Power Parity Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness. Copyright © 2000 Ian H. Giddy International Financial Management 48

Inflation & Interest Rates US Expected Inflation Rate 2% Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10% Copyright © 2000 Ian H. Giddy International Financial Management 50

Inflation & Interest Rates US Expected Inflation Rate 2% Canadian Expected Inflation Rate 7% US Interest Rate 5% Canadian Interest Rate 10% Expected Rate of Change of the Exchange Rate Copyright © 2000 Ian H. Giddy International Financial Management 51

Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Buy Canadian Dollars Forward (at discount of 5%) Copyright © 2000 Ian H. Giddy International Financial Management 53

Inflation & Interest Rates Borrow at US Interest Rate 5% Invest at Canadian Interest Rate 10% Buy Canadian Dollars Forward (at discount of 5%) Buy Canadian Dollar Futures (at discount of 5%) Copyright © 2000 Ian H. Giddy International Financial Management 54

The Linkages Again Relative excess money supply 1 2 4 Relative interest rates 5 Copyright © 2000 Ian H. Giddy Relative inflation rates Forward exchange premium or discount 3 Exchange rate change 6 International Financial Management 55

Conclusion: Corporate Exchange Rate Risk l Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies Copyright © 2000 Ian H. Giddy International Financial Management 57

Conclusion: Corporate Exchange Rate Risk l Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and to business risk. Relative monetary and fiscal policies Copyright © 2000 Ian H. Giddy Relative inflation Exchange rate change International Financial Management 58